Bank of Canada Should Factor Deflation Risk into Policy, IMF Says

The Canadian flag flies outside the Bank of Canada building in Ottawa.

Deflation is not an imminent threat for Canada, but the risk of a downward slide in prices is something the Bank of Canada should be very mindful of when setting interest rates, according to the International Monetary Fund’s chief Canada watcher.

The risk of deflation has become a worry globally as price pressures in advanced economies grow increasingly feeble, the process economists call “disinflation.”

Deflation, a sustained and outright drop in prices, hasn’t yet surfaced in any major economy.

But it’s on the radar.

The risk of deflation in Canada might not be as immediate for other economies with weaker growth. But yearly headline inflation in Canada has been consistently at or below the bottom of the Canadian central bank’s 1% to 3% target range for more than a year, and slipped to 0.7% in October.

And the Bank of Canada has signaled it’s aware of the downside risk to inflation prices in light of the long string of below-target inflation numbers.

The broad weakness in price pressure across a number of economists is hard to account for, Roberto Cardarelli, chief of the IMF team covering Canada, said a press briefing Wednesday.

“Inflation is a puzzle, and it’s not just a puzzle in Canada,” Mr. Cardarelli said.

It’s believed that one of the key drivers of inflation is the amount of slack in an economy – the difference between actual growth and the growth an economy could produce without pushing inflation higher.

It is also referred to as the “output gap,” as it’s the difference between an economy’s actual output and its potential output. When an economy is reaching full capacity, labor and other inputs become scarcer and more expensive, and that creates inflation.

But inflation in Canada remains soft despite the fact that the gap has narrowed considerably since the recession, Mr. Cardarelli said.

“At the peak of the Great Recession in 2009 we had underlying inflation where it is now, and we had an output gap twice as big,” he said.

The disconnect between smaller output gaps and price pressures seems to be calling into question the relationship between pricing and economic slack, Mr. he said.

Nonetheless, the IMF expects inflation will pick up as the economy continues to grow, albeit at a sluggish pace.

But the potential problems created by deflation are so serious, it’s better for central banks to err on the side of lower interest rates rather than higher, which could squelch growth and make deflation even more likely, Mr. Cardarelli said.

“You want to avoid the risk of inflation much more than you want to avoid the risk of overheating down the road,” he said.

“It’s a risk that has to be taken into account in monetary policy,” he said.

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